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This lesson is part of the following series:

In this video lesson, we'll look at changes in the Cost of Living and the CPI (Consumer Price Index). Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

About this Author

Founded in 1997, Thinkwell has succeeded in creating "next-generation" textbooks that help students learn and teachers teach. Capitalizing on the power of new technology, Thinkwell products prepare students more effectively for their coursework than any printed textbook can. Thinkwell has assembled a group of talented industry professionals who have shaped the company into the leading provider of technology-based textbooks. For more information about Thinkwell, please visit www.thinkwell.com or visit Thinkwell's Video Lesson Store at http://thinkwell.mindbites.com/.

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The newspaper says that the inflation rate is 3%, but I just came from the grocery store where my favorite loaf of bread now costs $1.25, and last year, it only cost a dollar. That's a 25% increase in just one year. On the other hand, a lot of things that I buy, their price haven't changed at all in the last year. And some of my favorite purchases, like my computer, software, movie rentals, their prices have actually fallen. How do we find the right number to indicate changes in households' cost of living? Well that's what the Bureau of Labor Statistics' Consumer Price Index is all about, and in this lesson we will look at where the Consumer Price Index comes from.
The Consumer Price Index, like all price indices, begins with some market basket of goods and services, and in the case of the Consumer Price Index, it's the market basket of goods and services that represents the typical purchases of a household. The Bureau of Labor Statistics looks at purchases that households make regularly and puts them in a basket with weights that represent their importance in the household budget. The basket is going to include important purchases like housing, food, clothing, transportation, medical care, entertainment, education, and other.
Now the trick is: what weights do we give each of these purchases? The Bureau of Labor Statistics looks at how much of each of these items households buy and how much they spend on them to determine the weights that each of these categories gets in the Consumer Price Index. This pie chart will then show how the Consumer Price Index is broken out into its components. 42% of the Consumer Price Index is housing costs, 15% of it is expenditures on food and beverages, 17% is transportation, medical care accounts for 6%, the clothing component is 4% of the CPI, entertainment is 6%, education is 6%, and the remaining 4% is other. The Consumer Price Index represents changes in the household cost of living and it's used to give us the most reliable measure of what's happening to inflation from the point of view of households and consumers. It's used across the economy. It's used by labor unions when they are negotiating collective bargaining or changes in their contracts with big employers. It's used by the government to make cost of living adjustments to social security and other government programs. It's also used by the U.S. Treasury to calculate the amount of payment to people who are holding inflation-indexed treasury bonds. It's also used by people trying to calculate the real interest rate. The real interest rate is your return on your savings actually measured in purchasing power. How much purchasing power are you getting back for the money that you put in the bank? And it turns out that that will be the difference between the nominal interest rate and the rate of inflation. If the bank is paying you a 5% nominal interest rate on your savings account, but the inflation rate is also equal to 5%, well you are not really getting any real return on your savings. The money the bank is paying you is just enough to keep up with rising prices.
There are other price indices. For instance, the Producer Price Index, which is based on a basket of things you may never buy, like pig iron and raw aluminum and stuff like that--the raw materials that businesses use to make the final goods and services that show up in the Consumer Price Index. It does turn out that changes in the Producer Price Index foreshadow what's going to happen down the road to the Consumer Price Index. If raw materials prices are increasing, you can bet that they are coming soon to a shelf near you as businesses pass rising costs onto consumers in the form of higher prices for final goods and services.
This then has been a quick look at the Consumer Price Index, the most reliable gauge to what's happening to the prices that households pay and to their cost of living.
Macroeconomic Measurements
Cost of Living
Changes in the Cost of Living and the CPI Page [1 of 1]

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